Worry About Narrowing European Spreads

By Alen Mattich

EPA

German Chancellor, Angela Merkel

The big fear of investors about the outlook for the euro has shown up in a hefty widening of sovereign spreads.

But a narrowing won’t necessarily be good news either. The increase in individual country risk premium across Europe’s periphery highlights the strains the single currency is suffering. The spreads over equivalent German bunds are read as a likelihood these countries default or leave the single currency and re-adopt their own currency.

But what if they don’t?

Almost certainly spreads would come in. That’s because either the European Central Bank will have started buying bonds or euro-zone governments will have agreed some formula of fiscal integration plus euro bonds. Not all of the narrowing, however, will come from demand for hitherto poorly performing sovereign debt. There will–or should–be a sell-off of core bonds at the same time.

Unsterilized ECB bond buying would be a strong signal that the central bank has abandoned its price stability remit and is willing to accept higher rates of inflation. This won’t be good for German bonds because that inflation is most likely to register in core countries whose economies are already operating at close to capacity.

If, on the other hand, a euro bond is agreed, in effect it means Germany and the rest of the core have agreed to pick up the bill. Oh sure, countries at the periphery will agree to structural changes in their economy and to strict rules on debt and deficits. But those rules will be broken. Investors know that and German debt will consequently suffer. Already there are signs of this shift in sentiment. A buyers’ strike on the latest auction of 10-year bunds this week showed which way the wind is blowing.

In 1994, the yield on German 10-year bunds averaged 6.8%. During the same year, German CPI inflation averaged 2.7%, giving a real return of 4.1%. In 1995, the yield on German 10-year bunds also averaged 6.8%, with an average CPI of 1.7%, leaving investors with a real return of 5.1%. In 1996, the average real return was 5%.

Fast forward to 2010 and the average real yield was 1.6%. So far this year, it’s less than 0.5%, according to the IMF’s projection for German CPI this year. Ultimately, investors will demand a little more for their money. If the world is going back to the pre-euro euphoria of the early- to mid-1990s, German 10-year yields ought to start looking more like 5% to 6%, based on IMF inflation projections. That’s a long way for bunds to fall. And a lot of potential spread narrowing.

Comments (2 of 2)

Of course, that says it all. Not if but when the Euro breaks. Truck has been saying this all along on this blog. It makes no common sense that the German taxpayers will continue to subsidize the Italians, the Greeks, The Portuguese or anyone else. I wouldn't subsidize my big spender neighbor nor would you. The Euro will collapse under its own weight and it only a question of time when the Euro zone and the banks stop trying to kick this can down the road. Turn out the lights, the party is over.

2:40 pm November 25, 2011

dwb wrote:

Forward inflation expectations in the ECB/Germany are already extremely low indicating a recession and potential deflation in Germany already. Germany can engage in fiscal austerity to counter any inflation. The ECB does not mere owe price stability to Germany, but also to Italy, Spain, and the remainder of the Euro zone - most of which right now is already in deflation. Once the Euro breaks, Germany will suffer under the weight of a recession that will crush the export machine. The weight of the bank bailouts will fall only Germany and France. Unfortunately, just as in 1936 orthodox devotion to the gold standard worsened the deflation until the continent broke, Germany and the ECB will go down as the defenders of a union that will not exist inside of a year.

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